With the new tax bill that was passed last December, it makes sense to take a (another) look at converting your traditional IRA to a Roth IRA.
What’s the difference between a traditional IRA and a Roth IRA?
When you contribute to a traditional IRA, contributions you make are tax-deductible in the taxable year you make them, subject to income limits. This defers the income tax you’ll eventually pay on these funds until you decide to withdrawal them or Uncle Sam forces you to start taking required minimum distributions (RMDs) starting at age 70 1/2. The theory is that the taxes you’ll save in the year you make the contribution will be more that the taxes that you”ll pay in the future year when you take a distribution.
When you contribute to a Roth IRA, the argument reverses. Contributions into Roth IRAs provide no current year tax deduction. However, funds can be withdrawn tax-free in the future regardless of age with a few caveats.There are income limits for current year contributions to a Roth IRA, but there are no restrictions on transferring an existing traditional IRA to a Roth.
Why consider this conversion now?
In the past, one of the primary arguments for converting to a Roth now was that income tax rates had nowhere to go but up. By paying the income tax rate now at a lower rate, the argument goes, one would save on income taxes over time as their tax bill would be higher in the future. The new tax bill lowers rates on all levels of income, making this argument even more compelling.
Of course, Congress may surprise us and lower rates again at some point. But with deficits projected to top $1 trillion per year for the next few years, the likelihood of still lower income taxes seems remote.
Why not convert a traditional IRA to a Roth?
When converting from a traditional IRA to a Roth IRA, additional income taxes are due in the current year when, theoretically, they would be less than at some time in the future. To maximize this benefit, the funds in the retirement account should not be used to pay the additional income taxes that will be due because of the conversion. If you use the funds inside of your traditional IRA to pay the tax bill, the benefit you will receive will be substantially diminished.
If you need to sell stocks from a taxable brokerage account to pay the income taxes on the conversion, consider selling the stocks in which you currently have a paper loss first. By generating that loss, you can further reduce the amount of income tax that will be due in the current year. If you need to raise cash for the income tax bill by selling stocks with a short-term gain, the additional tax due may reduce or eliminate the benefit you can receive.
Please call me at (610) 999-3599 for a no-cost, no-obligation phone consultation if you’d like to learn more this and other financial topics.